Agenda, 11.7.12• Check 30/31• Review LPM & LFM• Budget Balance• Interest Rates & Monetary Policy• Read: 32/33 (Unit 5 guide posted)

Review• Draw a Liquidity Preference Model• What causes shifts?

• Draw a Loanable Funds Market Model• What causes shifts?

• Fisher Effect = inflation does not effect S/D of Loanable Funds, Nominal interest rate just rises that much (because real = nominal – interest rate)

Budget Balance• Savings of Govt = Taxes – Govt Spending – Transfers• Deficit versus surplus

• Business Cycle affects deficits and surpluses• During recessions, larger deficit, during expansion, smaller

deficit or even surplus• Automatic stabilizers cause this• To measure budget balance without business cycle use

cyclically adjusted budget balance• What would balance be if rGDP = potential output• If there is a recess. Gap, would + tax revenue, lower transfers• If there is an expan. Gap, would – tax revenue, raise transfers

Long range debt• Budget balance – is it important? Is a deficit bad? • IT DEPENDS

• Long Range: we measure in fiscal years (Oct to Sept)• Debt Rolls over• Measured in public debt & total debt• Govt pays interest on debt, can borrow to cover debt• Govt could default on debt (Argentina)

• Debt/GDP ratio – you want a low ratio, you want your GDP to grow more than your debt

• Implicit Liabilities = spending promises• US has Medicare, Medicaid, Social Security • Govt will owe that in future

Monetary Policy/Interest Rate• Fed sets target federal funds rate (6 week period)• How do they get the rate there? OMO usually (rarely dw or

RR)

• Interest Rate change affects AD – how?• Fed increases MS, lowers interest rate, more investment

spending, higher real GDP, higher consumer spending, leads to higher Agg Demand

• Will contract with inflationary gap (contrationary monetary policies)• Higher interest rates = less inflation

Monetary Policy/Interest Rate

• Taylor Rule says you should consider• FFR = 1 + (1.5X inflation rate) + (.5Xoutput gap)

• Some countries set inflation target rate • US does not but we stay in a safe range

Agenda, 11.9.12• Check 32/33• Practice FRQ• Prices/Output in the Long Run• Inflation

• HW: Module 34

Practice• Pg 314, #2

Module 32• How an increase in the money supply affects the short run and the long run

• Short run: increase in MS increases AD which pushes price levels up

• Long run: SRAS eventually adjusts (rise in nominal wages after the “Sticky wages” unstick) and back to LRE but with a higher agg price level

• (And the opposite happens with decrease in MS)

Module 32• Monetary Neutrality:• Change in money supply leads to proportional change in

price level in the long run

• So if MS rises by 5%, agg price levels rise by 5% too

• Economists concern themselves with the short run affects of MS though

Module 32• Money Supply/Interest Rate in LR• Money Supply increases, Interest Rate lowers

• Interest Rate lower equals more AD, which raises price levels

• Higher price levels lead to more money demanded

• Interest rate ends up back where it was

Module 33• Nominal MS (M) versus the real quantity of money (M//P)

• Classical Model of Price Level:• Ignore transition period of increased AD and think of price

level rising automatically• Assumes Real GDP never changes in response to the

change in money supply• Doesn’t work in periods of low inflation• Is applicable in periods of high inflation (quicker

adjustment of wages and prices)

Module 33• Inflation Tax• When governments prints own money it drives inflation up

(increased MS = increased APL)

• Reduces the purchasing power of the people’s money

• Inflation tax = reduction in the value of the money held by the public

• Inflation tax is = to rate of inflation

Module 33• Hyperinflation:• Seignorage is the revenue generated by government’s

right to print money

• Measure the effect of seignorage by measuring real seignorage (revenue created by printing money divided by price level)

• Inflation spirals out of control as more money is printed to cover printed money

Module 33• Moderate Inflation:• Cost push: • Cost of integral good goes up

• Demand Pull:• Agg demand leads to higher prices of goods when it outpaces

agg supply

• Politics and Inflation:• Policies that help economy can lead to inflation• Policies to reduce inflation (deflation) can lead to

depressed economies• Short term gains are appealing to politicians

Module 33• Unemployment and Output Gap:• Output gap = difference between Real GDP and potential

output

• If Output gap is positive (inflationary gap), unemployment will be lower than natural rate

• Output gap negative (recessionary gap), unemployment will be higher than natural rate

Agenda, 11.13.12• Check M34• Practice: Pg 330, Free Response Questions• Video: Phillips Curve• Key Concepts: M34

HW: 35/36Thursday: Discuss 35/36, Distribute Review Materials

***Model UN Friday = questions in Y block Thurs

Module 34• Phillips Curve: http://www.youtube.com/watch?v=jFKZqi1Bl-k• Basic idea: lower unemployment leads to higher inflation (caused by changes in AD/AS curves)

• Phillips Curve represents inflation rate (change in agg price level) & unemployment rate• SHORT RUN (SRPC) is a negative relationship• LONG RUN (LRPC) shows no relationship (vertical line)

• Expectations about future & supply shocks affect SRPC (positive/negative)

Module 34• SRPC will raise with expected inflation (and lower with expected disinflation)• Idea = accelerating inflation• Won’t accelerate at NAIRU (natural rate hypothesis)• NAIRU = nonaccelerating inflation rate of unemployment• NAIRU = LRPC

• Unemployment below NAIRU will mean + change in inflation rate, below NAIRU means – change in inflation rate

• NAIRU is estimated by economists

Module 34• Disinflation = contractionary policies to slow inflation• Lowers Real GDP, can hurt economy but is necessary• Less effect if the central bank states intentions

• Deflation is one result – dollar has higher value in the future• Leads to lower agg. demand• = debt deflation (cycle of further deflation)

• Deflation affects nominal interest rates (Fisher Effect)• Zero bound IR = won’t go below zero• = liquidity trap – when conventional monetary policies can’t

be used because of a zero bound IR

Practice• FRQ on 341